Tuesday, March 13, 2012

The Expenditure Rule

The upcoming referendum on the Fiscal Stability Treaty (FST) has brought the fiscal rules contained in the treaty to the forefront of our attention. However, as has been said a number of times when it comes to the numerical rules in the Treaty there is nothing new.

The ‘balanced-budget rule’ has been in place since 2005 and actually in the guise it was originally proposed was even more stringent than the current version.

The range for the country-specific MTOs for euro area and ERM II Member States would thus be, in cyclically adjusted terms, net of one-off and temporary measures, between -1% of GDP for low debt/high potential growth countries and balance or surplus for high debt/low potential growth countries.

High debt countries are actually allowed a structural deficit of 0.5% of GDP under the Treaty. The ‘debt brake rule’ is from the revised Stability and Growth Pact (SGP))agreed last year.

What is perhaps of interest is the fiscal rules in the revised SGP that did not make it into the FST and it is not clear why some elements of the SGP were omitted. The focus of the Fiscal Compact is on debt and deficits but the focus on the SGP is much broader. The revised SGP includes a government expenditure rule and a Macroeconomic Imbalance Procedure.

The rules in the Fiscal Compact would not have had any impact in Ireland were they in place from 2000 to 2007. Ireland ran overall budget surpluses, the EC estimated at the time that Ireland was running structural surpluses and the debt ratio fell to 25% of GDP by 2007.

The fiscal rules in the Treaty would not have limited fiscal policy in Ireland in the run up to the crisis in any way. Under the terms of the Treaty Ireland would have been fiscally sound. However, this would not be the case if the full gamut of features of the SGP are considered.

When the Six Pack was agreed last October by the EU Council it was stated that:

the reform introduces an expenditure benchmark, which implies that annual expenditure growth should not exceed a reference medium-term rate of GDP growth.

The reference-medium-term rate of potential GDP growth is based on regularly updated forward-looking projections and backward-looking estimates, taking into account the relevant calculation method provided by the EPC. The reference-medium-term rate of potential GDP growth will be the average of the estimates of the previous 5 years, the estimate for the current year and the projections for the following 4 years.

The government expenditure aggregate to be assessed should exclude:

interest expenditure,

expenditure on EU programmes fully matched by EU funds revenue, and

non-discretionary changes in unemployment benefit expenditure.

Due to the potentially very high variability of investment expenditure, especially in the case of small Member States, the government expenditure aggregate should be adjusted by averaging investment expenditure over 4 years.

It is unlikely that this rule will be assessed retrospectively but we can provide a crude analysis using some existing data. Here is a summary of the findings. Click to enlarge.

The adjusted government expenditure is found by starting with total general government expenditure in the eurostat government finance statistics subtracting interest expenditure, investment expenditure and EU receipts (taken from Table 10 here) and adding in the four-year moving average of investment expenditure. No adjustment is made for non-discretionary changes in unemployment benefit expenditure.

The potential growth rates are taken from the archive of estimates provided on the CIRCA website of the European Commission: Economic and Financial Affairs. The estimates for each year are the Autumn estimates provided by the Commission in that year except for 2001 and 2002 both of which are based on the Spring 2002 estimates.

The results are clear. In each year from 2001 to 2007 the increase in government expenditure was above that which would have been allowed under the proposed expenditure rule. Over the seven years adjusted government expenditure increased by 130%, with an increase less than half of that allowed under the rule.

The 2001 Budget led to the first official rebuke of a eurozone country’s budget by the Commission and the Council of Ministers declared:

… the Council finds that the planned contribution of fiscal policy to the macroeconomic policy mix in Ireland is inappropriate. The Council recalls that it has repeatedly urged the Irish authorities, most recently in its 2000 broad guidelines of the economic policies, to ensure economic stability by means of fiscal policy. The Council regrets that this advice was not reflected in the budget for 2001, despite developments in the course of 2000 indicating an increasing extent of overheating. The Council considers that Irish fiscal policy in 2001 is not consistent with the broad guidelines of the economic policies as regards budgetary policy. The Council has therefore decided, together with this Opinion, to make a recommendation under Article 99(4) of the Treaty establishing the European Community with a view to ending this inconsistency.

Charlie McCreevey did not change the budget and although the rate of expenditure increase was tempered, for each year after 2001 expenditure increased by more than would be allowed by the rule. Of course, even if the rule were in place there is no guarantee that it would have been respected. There is always a get-out clause and for the expenditure rule the SGP further states:

A Member State that has overachieved the MTO could temporarily let annual expenditure growth exceed a reference medium-term rate of potential GDP growth as long as, taking into account the possibility of significant revenue windfalls, the MTO is respected throughout the programme period.

Though I’m not sure that breaking the rule for at least seven years would be considered temporary.